How Low Can Bitcoin Go?

Summary

Trading View (next 2-4 weeks): We like to be bearish bitcoin.

Investment View (next 1-3 years): We like to be long bitcoin.

Big Picture

• According to one valuation metric, crypto is undervalued.
• The bitcoin and equity correlation remains high.
• The probability of recession within the next 12 months is back up to 50%.
• The macro backdrop remains bearish.

On-Chain/Flow Signals

• Our metrics are split this week: one bullish signal, four bearish signals, one neutral signal.

Overall View

• With the macro backdrop still bearish, and our on-chain/flow signals bearish overall, our overall view remains bearish bitcoin (Chart 1).

Macro: Is Bitcoin Undervalued?

Bitcoin is currently amid a 57% drawdown since its November high of $67,734, while ethereum is experiencing a 59% drawdown from its high of $4,799. Recently, both have been trading sideways. Optimistically, this could mean we are at the lows and could see moves higher. But more likely this is a pause before another downward leg. We think the Fed is not done with an aggressive hiking cycle, and recession risks are increasing. This means macro is weighing on crypto. The question, then, is how low could crypto go? Are we at extreme undervaluation levels, or is more meaningful downside possible?

What Is the MVRV Valuation Metric Saying? $24,000 and $16,000 for Bitcoin

There is no perfect valuation metric for crypto, but we like the MVRV Z-score approach. This has parallels with the price-book ratio in equities but is calculated from the investor side. It examines the current market cap of crypto against the price at which investors bought in. So, it can show whether a cryptocurrency is over/undervalued relative to its fair value. When market cap is significantly higher than realised cap, this has historically signalled market tops. The opposite is true when market cap is significantly below realised cap.

Currently, the MVRV Z-score for bitcoin and ethereum are 0.39 and 0.16, respectively (Charts 2 and 3). These are historically undervalued levels for both and are the lowest values since early 2020, after which markets rallied. But we have seen lower. We can assess what prices would take crypto to extreme undervaluation levels:

• The first threshold is if the MVRV Z-score dropped to 0. This means market cap is equal to realised cap. To reach this level, bitcoin must hit $23,791, and ethereum $1,825.
• The second more extreme threshold would be if the MVRV Z-score dropped to its lowest levels since 2017. This would be -0.51 and -0.66 for bitcoin and ethereum, respectively. To reach these levels, bitcoin must fall to $16,460 and ethereum to $1,075.

What About a Repeat of the Dot-Com Crash? Bitcoin to $8,250

Another exercise is to see how low prices could get were the NASDAQ to suffer a 2000-style crash. After all, the bitcoin and NASDAQ correlation remains around 80%. So where the NASDAQ goes, bitcoin follows.

Back in 2000, the NASDAQ suffered a 78% drawdown (Table 1). Currently, the NASDAQ is in a 30% drawdown. A repeat of the 2000-style drawdown would put the NASDAQ at 3,500. So where would crypto be if NASDAQ were trading at this level? We estimate a regression between bitcoin/ethereum returns and NASDAQ returns from 2020 onwards. Based on this relationship, we find:

• Bitcoin prices would reach $8,254 if the NASDAQ fell to 3,500. This implies a 72% decline from current levels.
• Ethereum prices would reach $143 if the NASDAQ fell to 3,500. This implies a 92% decline from current levels.

Crypto Sentiment

The third factor to consider is crypto-specific sentiment. Regulation is becoming more of a theme throughout 2022, with various executive orders signed already. Increased regulation should mean less uncertainty around crypto markets for investors, which would be bullish.

On the flip side, overregulation could stifle innovation. The ongoing regulatory backdrop will be key to monitor. Lastly, on ethereum specifically, there is the much-anticipated merge. We previously covered its potential implications. The punchline was that it should be bullish for ethereum for five main reasons:

1. The ability to earn yield on staked ETH will attract more investors to the space.
2. Net issuance will drop post merge; the reduction in supply should be bullish for ethereum.
3. Increased scalability and security.
4. Ethereum may become deflationary.
5. ESG concerns around proof-of-work (PoW) should be alleviated as ethereum transitions to proof-of-stake (PoS) – ditching the energy-intensive mining process that is ubiquitous with PoW currencies (e.g., bitcoin).

On-Chain/Flow: ETF Outflows

One metric is giving a bullish signal this week:

• Futures open interest and perpetual funding rates trending up.

Four metrics are giving bearish signals:

• ETF outflows resume.
• Bias for exchange inflows.
• Reduced profitability of the coin supply and realised losses on chain.
• Hash rate and miner revenues decline.

Lastly, the remaining metric is giving a neutral signal:

• Some longer-term HODLers have sold, but the 1y+ vintage still dominates over 65% of the current coin supply.

On balance, on-chain/flow metrics are giving a bearish signal. Here are the details of each metric (with explanations in the Appendix).

Institutional Demand: Bearish Bitcoin

Our preferred metric to track institutional demand is flows into bitcoin ETFs. The recent pocket of inflows was patchy and brief – we are seeing outflows again (Chart 4). This is bearish bitcoin.

Demand for Liquidity and Exchange Activity: Bearish Bitcoin

In the short term, a bias for inflows from exchanges exists. Net 9,600 and 53,000 coins entered exchanges over the past seven and 14 days, respectively (Chart 5). There have been some singular instances of large inflow spikes recently too – 52,000 coins entered exchanges on 9 May alone. This is bearish bitcoin.

Longer term, the 30-day change in the exchange balance reveals fluctuations in the supply held on exchanges month on month. This metric has now flipped into positive territory after being negative since March (Chart 6). This means exchange balance is increasing relative to the last 30 days, which is bearish for bitcoin.

A bias for exchange inflows in the short term and the longer term is bearish bitcoin.

Futures Activity: Bullish Bitcoin

Futures open interest is trending up over the past week – it is currently $13.2bn, up 6% over the past seven days (Chart 7). Around $8.8bn (66%) of this comes from perpetual futures contracts. This is bullish for bitcoin.

Perpetual funding rates reveal the directional bias of investors. On average, they have resumed an uptrend over the past week (Chart 8). We would be cautious around this in the short term as we would like to see an uptrend for a meaningful period. Nonetheless, this is a bullish signal for bitcoin.

HODLers: Neutral Bitcoin

The 30-day moving average of the coin days destroyed (CDD) metric ticked up over the past week (Chart 9), indicating increased older coin selling. The 1y+ revived supply metric confirms this – it is also up over the same period (Chart 10). Most of the coin supply (65%) have been accumulating for a year or more (Chart 11). This vintage has been increasing throughout 2022.

Some older hands selling can be viewed as bearish for bitcoin as investors move in to take profits before prices decline further. However, a significant majority of the coin supply has not moved in at least a year despite the recent, tumultuous price action – there is still a strong conviction to HODL among these investors. Together, we view these HODLer metrics as neutral for bitcoin.

Investor Profit and Loss: Bearish Bitcoin

The percentage of circulating supply in profit (PSIP) has dropped to 59% (Chart 12). That is down 2pp over the past seven days. Net unrealised profit/loss (NUPL) is now 0.2 – down 2pp over the past seven days (Chart 13). Lastly, SOPR is still showing a bias for realised losses on chain with a value of less than one for 13 of the last 14 days (Chart 14). Further back, it has been less than one for 28 of the last 30 days – meaning just two days of realised profits on-chain over the past 30 days.

Overall, the reduced profitability of the coin supply and realised losses on chain are bearish for bitcoin.

Mining Activity: Bearish Bitcoin

The hash rate is down 17% over the past 14 days (Chart 15). Miner revenues have followed suit – they are down 32% over the past 14 days (Chart 16). Together, these metrics are bearish for bitcoin.

Bottom Line

We have introduced a framework for understanding the flow and microstructure dynamics of bitcoin markets. The six key metrics are:

1. Institutional demand: ETF outflows. Bearish bitcoin.
2. Liquidity demand: long-term and short-term bias for exchange inflows. Bearish bitcoin.
3. Futures activity: futures open interest and perpetual funding rates are trending up. Bullish bitcoin.
4. HODLer behaviour: some older hands have sold, but the long-term HODLer vintage maintain conviction despite negative price action. Neutral bitcoin.
5. P&L of investors: decreased profitability of the coin supply and a bias for realised losses on chain. Bearish bitcoin.
6. Mining activity: hash rate and miner revenues decreasing. Bearish bitcoin.

Appendix

Institutional Demand

Perhaps the largest institutional vehicle for bitcoin is the Grayscale Trust, with over $27bn in assets. It invests solely in BTC, and so many investors, notably institutional, who cannot hold BTC directly can get exposure through investing in Grayscale. Consequently, if the trust trades at a premium to BTC prices, it may imply ‘excess’ demand from institutions, but ‘excess’ supply if it trades at a discount. Alternatively, the discount may suggest investors have found other ways to get exposure to BTC, whether through ETFs or directly holding BTC. We therefore focus on how the discount has changed in recent months to gauge investor interest.  Alternatively, investors may be using other vehicles to get exposure such as ETFs or holding BTC directly. We put more weight on BTC flows than the Grayscale premium.

Liquidity Demand

Another measure of cryptocurrency bullishness is whether investors are willing to hold it in illiquid form (e.g., a private wallet) or prefer a liquid form (e.g., on an exchange). The former would suggest investors are bullish, as they are comfortable with being unable to sell easily. Conversely, holding it in liquid form would suggest investors are bearish, as they prefer being able to sell easily.

Therefore, large flows onto crypto exchanges would suggest investors want to convert their holdings to a more liquid form, implying more bearishness.

Futures Activity

We track the growing market of bitcoin futures. Open interest – the sum of long and short contracts – is a good measure of investor interest.

Perpetual funding rates reveal the directional bias of investors. Exchanges set funding rates to prevent a lasting divergence in the price of the futures contract and the underlying since perpetual contracts have no expiry date so never settle in the traditional sense. Consequently, we can interpret funding rates as the cost of holding bitcoin via perpetual futures. Positive funding rates imply longs pay shorts and vice versa. We use it as a proxy for trader sentiment since a positive funding rate implies traders are paying a premium to keep open long positions.

HODLers

In our introductory bitcoin flow framework, we explained ‘HODLers’ and ‘HODLing’. HODLing refers to buy-and-hold strategies in the context of bitcoin and other cryptocurrencies. Those who HODL for extended periods are die-hard adherents.

We can categorise HODLers by the length of time they have held BTC. We define long-term or staunch HODLers as those who bought BTC five or more years ago and have held it ever since, medium-term HODLers as those who bought 6-12 months ago, and short-term HODLers as those who bought 3-6 months ago.

The coin days destroyed (CDD) metric is defined as the number of coins in a transaction multiplied by the number of days since the coins were last spent. So, increasing CDD suggests older coins are being spent (more coin days are destroyed) and vice-versa.

Profit and Loss

The percent supply in profit (PSIP). This tracks the share of circulating BTC supply in profit. That is the percentage of circulating BTC whose current price is higher than when it was last transacted (movement).

Net unrealized profit and loss (NUPL). This is the ratio of unrealised profits over total market capitalisation. While PSIP just focuses on whether BTC coins are in profit or not, the NUPL focuses on the size of profits. So, we could have a situation where the PSIP is low – that is, a low share of supply is in profit – but the NUPL could be high if the size of those profits is large.

Spent output profit ratio (SOPR). While PSIP and NUPL focus on unrealised profits or mark-to-market, this measure focuses on realised profits. SOPR is the realised value of a transaction divided by the value at initiation (or creation) – more simply, price sold divided by price paid. If SOPR is above one, investors in aggregate have realised profits, while below one means they have realised losses. In broad uptrends, SOPR spends a significant amount of time above one, whereas the opposite is true for broad downtrends.

When SOPR is rising, sellers are increasingly realising profits. The opposite is true when it is falling. A price rally with a flatter SOPR trend indicates investors are not yet realising their profits with the rally. The reluctance of investors to sell and realise a profit may be because they believe the price will increase further, which would be bullish. At the same time, more profit taking could precede a correction. Typically, buying as SOPR moves around one during bullish periods has proven to be a profitable strategy.

Mining Activity

Computing power is central to the crypto market. Miners use advanced computing hardware to solve complex problems that confirm BTC (and other coins) transactions on the public ledger or blockchain. The miners are rewarded with new coins for their efforts. A measure of the complexity of the problems and so the computing performance required to solve them is the hash rate. The higher this rate, the more computing performance is needed to maintain the blockchain. The rate can fluctuate depending on demand for crypto.

Dalvir Mandara is a Quantitative Researcher at Macro Hive. Dalvir has a BSc Mathematics and Computer Science and an MSc Mathematical Finance both from the University of Birmingham. His areas of interest are in the applications of machine learning, deep learning and alternative data for predictive modelling of financial markets.